Monday, March 14, 2011

The Wrath of Keynes, or, The Fall of the House of Hayek, Part VII

One of the most remarkable statements made by John Maynard Keynes in his Treatise on Money — trashed for its inherent collectivism by Friedrich von Hayek — was Keynes's declaration that the State, consistent with the growth of its absolutism, has the right and the power to "re-edit the dictionary."  (It's on pages 4 and 5 of Volume I, if you care to look it up.)

Perhaps even more remarkable than Keynes's blatant declaration of such absolute State power was that von Hayek seems to have missed it in his famous and justified critique of the Treatise. This is only comprehensible when we consider that both Keynes and von Hayek were firmly ensconced in the Currency School of finance, and the Currency School is just as solidly established on the shifting sand of relativism, of which the single most important — and obvious — symptom is the redefinition of money.

The legal and accounting definition of money — and the definition used by those schools of economics based on the British Banking School of finance — is "anything that can be used to settle a debt." This is the "substantial" definition of money. For its part, however, the Currency School and those schools of economics based on Currency School principles (rejection or redefinition of Say's Law, exclusive reliance on existing accumulations of savings to finance new capital formation, and rejection of the real bills doctrine) restrict their understanding of money to the functional definition, and then restrict the term money itself to currency and "currency substitutes."

This highlights the necessity of being very careful with the terms we use, especially in how we define them. In Banking School terms, for example, the phrase "moneyless economy" is meaningless. In Currency School terms, it makes perfect sense.

As another example, take the recent discussions within the Global Justice Movement over whether it is an application of basic principles of binary economics for the State to create money to finance education or home ownership, an allowable expedient, or directly opposed to essential principles of binary economics. Is this "good credit" or "bad credit"?

This is a extremely complex question. Even to discuss the matter, we have to set aside for the sake of the argument the principle that neither the State nor banks actually "create" money. (The State effectively mortgages future tax collections, while banks exchange one form of money — bills of exchange — for another, the bank's own promissory notes. In neither case is there a question of "money creation.")

Distinguishing between bad credit and good credit is not the same as saying it's a bad idea to borrow to buy a house or to finance an education. Not to try and get too confusing, but we can classify both as good uses of bad credit — depending on the source of the money.

The key to understanding this is that there are two sources of this thing we call "money," in legal and accounting terms defined as "anything that can be used to settle a debt." Unfortunately, most of modern economics (notably the three mainstream schools of economics, the Keynesian, Monetarist/Chicago, and Austrian) recognize only one source of money: unconsumed production.

That is, according to most current thinking, the only way to save is to reduce consumption, accumulate the savings in the form of cash or cash substitutes (e.g., time deposits), then invest. This provides the economy with the "supply of loanable funds," and determines the "production possibilities curve."

The supply of loanable funds may be used for consumption (including housing and education) or investment. If there is not enough investment, Keynesian theory says that you increase the amount of the currency, shifting purchasing power away from consumers and to producers for reinvestment via inflation. Austrian theory says you leave the amount of the currency alone and let the interest rate rise to lure more money away from consumption and into reinvestment.

Both theories (the Monetarist/Chicago theory is a combination of Keynesian and Austrian, and is too complicated to go into for this discussion) fail to take two important factors into consideration. As explained by Dr. Harold Moulton, president of the Brookings Institution from 1916 to 1952, in his book, The Formation of Capital (1935),

1. Cutting consumption to accumulate financing for new capital formation means that the new capital is more likely to fail due to insufficient consumer demand, and

2. The actual financing for new capital formation has almost always come not from restricting consumption and accumulating unconsumed production ("saving"), but from the expansion of commercial bank credit by exchanging "private money" issued by individuals and businesses in the form of "bills of exchange" drawn on the present value of existing or future marketable goods and services, for the bank's promissory notes (banknotes/currency) or demand deposits (checking accounts). Commercial banks ("banks of issue") — including the Federal Reserve and other central banks — do not create money. All they do is exchange "private money" for a more useful and convenient form. (This is called the "real bills doctrine," and is rejected by all three mainstream schools of economics.)

There are thus two types of banks, the "bank of deposit," and the "bank of issue." A bank of deposit is defined as a financial institution that takes deposits and makes loans. That is, it can only lend out accumulated savings. A bank of deposit is the proper place for a student or prospective homeowner to go to borrow money. The most common forms of deposit bank are savings and loans and credit unions, although investment banks are, properly speaking, also deposit banks.

The bank of issue is defined as a financial institution that takes deposits, makes loans, and issues promissory notes. The most common type of issue bank is the commercial or mercantile bank, which is (or is supposed to be) in the business of exchanging "private money" created by individuals and businesses by drawing bills of exchange, for the more generally acceptable promissory notes and demand deposits issued or held by the bank. A central bank is essentially a bank of issue for banks of issue to ensure adequate liquidity and a uniform currency that passes at par among all the member banks.

The idea of the real bills doctrine as implemented by commercial banks and backed up by a central bank is that there should always be enough "money" to fund all financially feasible projects that have a present value, even if the marketable goods and services expected to result from the project do not yet exist, and the factory hasn't even been built. Creating money in this fashion and using it for productive purposes is "good" debt or credit.

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